The New Partnership Audit Regime and What It Means for Tax-Exempt Investors

*This article was originally published in the October 2018 edition of The NAPPA Report

Effective January 1, 2018, the new centralized audit regime for all partnerships and LLCs taxed as partnerships went into effect. The aim of the new regime is to make it easier for the IRS to conduct audits of partnerships by letting the IRS focus for both audit and collection on the partnership and not on the individual partners. The IRS can now deal exclusively with the Partnership Representative who is given substantial powers not given to the “tax matters partner” under prior law.

Under the new audit regime any adjustments to the partnership’s income, gain, loss, deduction, credit and the like and any allocable share of those items is made at the partnership level. More importantly, any underpayment is likewise assessed and collected at the partnership level, absent certain elections made by the Partnership Representative.

The Partnership Representative now has exclusive authority to bind the partnership and deal with the IRS on the following:

waiving any statute of limitations or other defenses;

conducting all communications with the IRS;

settling the tax liability of all partners; and

deciding whether to allocate any IRS assessment among the partners or paying the tax on the partners’ behalf at the partnership level.

In addition, there is no requirement that the IRS contact any of the partners or provide the partners with any right of appeal.

What can be done?

First, tax-exempt partners should understand who is named as the Partnership Representative under the partnership agreement (or operating agreement in the case of an LLC). Does that party, who need not be a partner, understand the nature of the partnership and more importantly the make-up of the partnership. For public pension fund investors in a partnership it is important that the Partnership Representative understand the tax-exempt status of those investors. The Partnership Representative should be aware of the partnership’s constituents. Tax-exempt investors will need to determine whether the Partnership Representative should be required to be knowledgeable of the issues that can arise when tax-exempt partners invest in a partnership, especially in a mixed pool of taxable and tax-exempt partners.

The partnership agreement should be reviewed to determine if it provides that the Partnership Representative is required to inform, or if appropriate seek approval from, the partners on the following matters:

electing out of the new audit regime if the partnership meets the requirements to make such an election;

notifying the partners when communications from the IRS occur;

seeking comment and response from the partners to any IRS inquiries in a timely manner;

permitting a partner’s attorney or accountant to participate in any audit;

deciding when to either waive the statute of limitations in connection with or settle an IRS audit;

informing the IRS that some (or all) of the partners are tax-exempt entities that should not be taxed at the presumed highest possible tax bracket absent proof to the contrary;

allocating any tax to be paid by the partnership or making an election to “push out” any tax payments; and

requiring former partners to be liable for any taxes assessed and collected on income earned when they held a partnership interest

Not all of the above items will necessarily be included in the agreement or any side letter. At a minimum the agreement or side letter should provide that any tax costs related to tax-exempt income should not be allocated to a tax-exempt partner so that the tax-exempt partner is not funding any tax liabilities on income that would otherwise be tax-exempt. In addition, the Partnership Representative should be directed to advise the IRS of the tax-exempt status of its partners prior to the conclusion of any audit.

However, even if these matters are addressed in the agreement, the IRS is not bound by any such provisions. Therefore, tax-exempt partners may want to consider whether the partnership agreement should also include a mechanism for any dispute resolution involving these matters if the Partnership Representative does not comply with the agreement . The partners may also want to consider whether the partnership should obtain an errors and omissions insurance policy to cover any inappropriate taxes, penalties and interest caused by the Partnership Representatives failure to follow any requirements that may be found in the partnership agreement.

Since tax-exempt entities often invest through partnerships to diversify their portfolios, the effect of the new centralized audit regime on their position as investors should be understood. This makes a review of the partnership provisions, including those provisions addressing the duties and obligations of the Partnership Representative under the new regime, all the more important. Some of the concerns raised above can be addressed in the partnership agreement or through a side letter so that the concerns of tax-exempt investors such as public pension funds can be properly addressed before any IRS audit occurs.